Back to the Future

The following is an excerpt from the Q4 2007 Vertex Managed Value Portfolio commentary:

“Our investment style has never been to pick trading points. Our process involves finding value, then looking out five years to assess how our companies will perform over that interval. Over short periods there are massive distortions in price-per-share vs. value- per-share. A classic case in point is Mattel, which is down 22% in a year and is flat over a five year period, despite a return on invested capital over 20%, a return on equity over 20%, a dividend growth rate of 71%, share buy backs of $1.5 billion dollars and an additional $500 million announced. When we first purchased Mattel shares, the company had $1.4 billion in debt now there is $900 million. The company has a dividend yield of 4.25%, roughly the equivalent of government bond yields. Let’s contrast this with CNQ, a Canadian energy company. CNQ is an excellent company – there’s no argument. Last year the stock was up 17%. Over five years it’s up 600%. Shares outstanding are the same, so net-net share buybacks and issues have been equal. Debt has gone from $4 billion to $10.6 billion, thus debt burden has significantly increased. Return on equity and return on invested capital are about equal to Mattel’s with the slightly better number being Mattel’s. Dividend growth rate is 22%, with a yield of 0.47%, which is roughly 1/9th that of Mattel’s. Mattel’s results are despite the trouble they’ve had with Barbie and various other issues. CNQ’s numbers include the best underlying conditions for its business, ever. If Mattel simply changed its name to Mattel Oil, it’s stock trajectory would look vastly different.”

DOC, ABOUT THE FUTURE . . .

Fast forward five years to today – as Mattel hits $41 (plus $4.49 in dividends) up from $19 and CNQ sits at $30 (plus $1.49 in dividends), down from $36 (it subsequently surged to a $55 high) – I can’t help but reminisce about the hate mail flooding my inbox at the time of writing that particular piece of prose, accusing me of making excuses for poor performance. This highlights the point about looking out five years rather than back five years when making investment decisions. Incidentally, Mattel still trades at a lower price to earnings multiple than CNQ, with Mattel at 14x and CNQ at 19x.

Comparison of Mattel vs CNQ since 12/31/07 (excl. dividends)

Moving on to other undervalued stocks, our investment in Property & Casualty insurance is working out very well, indeed. It is worth emphasizing that this is our largest portfolio weight and for good reason:

Partner Re, Platinum Re, Aspen Capital, Montpelier Re, Validus and XL all beat expectations for the 4thquarter; all announced additional share buy backs, yet again; some raised their dividends, again; all are now trading at 52 weak highs; while all remain priced under book value, as if they’re not even in business!

That’s a lot of “alls” and a lot to take in, but for the first time in probably 10 years an analyst or two mentioned the words “multiple expansion”. There is no group more deserving of it. These firms navigated through extremely tough times and still came out winners. Insurance pricing has been low, investment returns low and somehow through disciplined management, they have come out the other side.

HELLO . . . McFLY?

No sector is more undervalued today than that of the Electronic Manufacturing Services, commonly described using the acronym “EMS”. Our world continues to become more electronic and at an increasing rate. That trend isn’t going away. Whether it’s your automobile, phone, healthcare device, household appliance or things only in your imagination, they all require manufacturing. The major players making these products are Celestica (in Canada), Jabil and Flextronics. Our favorite is Jabil Circuit. Jabil is diversified, from communications to healthcare products. It’s a global powerhouse in “the space” and trades at 8x earnings despite growing earnings per share since the financial crisis from $.79 to $1.91, with an estimate of $2.15 for fiscal 2013.

Looking out at Jabil five years from now, odds are skewed in our favour for both a continued rise in earnings and a PE multiple expansion to let’s say equal to that of the stock market at 15x. Using an earnings growth rate of 10%, starting with 2012 earnings per share at $1.91 in 5 years, EPS should be $3.07. $3.07 multiplied by 15 (the market’s PE) equals $46.00. Jabil currently trades at $19.50. Furthermore, by adding in a current dividend yield of 1.5% we get an additional bonus. Regardless of our estimates, it’s going to be hard to lose money in Jabil over the next half decade – a classic case of flip tails and you don’t lose very much, flip heads and achieve a really nice return. It won’t be easy, as they’ll probably be plenty of reasons to be scared out of Jabil stock over the next five years. That’s just the way it is.

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